Post the Iran event, DM rates have dramtically repriced. In the four weeks since the bombing began in Iran, 10-year US treasury yields have climbed 48bp, from 3.94% to 4.42%. The 10yr UK gilts have climbed up by 75 bps and the 10yr German Bund yields have climbed up by 45 bps. In UK pre-Iran event rate cut pricing of 50 bps in REMCY26 has now changed to almost 3 hikes of 25 bps each in REMCY26. Similarly in EU, status quo for REMCY26 pre-Iran event has changed now to 3 hikes of 25 bps each in REMCY26. The current violent repricing seems to be a result of concentrated received positioning in a market priced for cuts and the scars of underestimating the 2022 inflation shock. Compared to other asset classes such as equities/fx, rates IVs have shot through the roof. The big question in those assets is whether we see a deeper and broader drawdown because the energy disruption from the Strait of Hormuz is longer-lasting and the market moves to worrying about severe growth downside. That would put more outright pressure on equities and EM, may provide some relief to the rates complex, and boost the Dollar further as it cuts against the prevailing trend of more globally diversified allocations. For 10yr UST yield fair value, we use the “golden rule” of French Nobel laureate Maurice Allais. The basic idea is that over the medium to long term, nominal GDP growth is a decent proxy for return on invested capital. Therefore, in any economy bond yields should tend to converge with the structural growth rate of nominal GDP. For US the 7 year moving average of annual nominal GDP growth is 5.9% against current 10yr UST level of 4.45%. But does that mean the 10 yr UST yields are too low? It depends upon how inflation actually shapes up in next 1-2 years. If inflation cools back to Fed's 2% target, then the fair value of 4.4% is justified. But if inflation were not to cool and remain elevated then an upward march in long end yields is assured. The last time these two scenarios—diverged as much as today was in the early 1970s. For several years, the bond market couldn’t make up its mind which scenario was right. But following the Yom Kippur War and the Arab oil embargo of October 1973, the bond market concluded the first scenario—higher inflation—was correct. But the story flips on the short end. Market pricing of many front ends now looks quite asymmetric across several scenarios—we think the hike risk priced in the US, and multiple hikes priced in Europe will prove too hawkish. From a fundamental standpoint, this repricing may be reflecting some scar tissue from the inflationary episode of 2022. And G10 central bankers’ focus on indirect and second-round effects and the risk of un-anchoring inflation expectations have clear echoes of that period. And if it were a growth shock as we expect it to be soon, the rates hikes currently being priced in might need to moderate. To summarise, while the long end rates have higher probability to remain elevated due to inflation expectations as well as probable fiscal measures needed to support growth, the short end rates in DM look attractive at current levels to receive for fading out the current rate hikes being priced. Hence, 2*10 curve steepeners as well as 1yr1yr rates look attractive to receive at these levels.
